Step-up in basis rule is an heir’s best friend

The step-up tax adjustment has been under siege for decades but has so far survived the onslaughts. The provision, which reduces capital gains tax for estates, has been controversial since the 1970s. Policymakers would still love to get their hands on the bonanza in tax revenues it represents.

There is a counterargument: If the law were repealed, assets held though multiple generations would suddenly become liable for substantial tax bills. Besides, imagine the misery of trawling through decades-old documentation to try to reconstitute transactions! In any case, the step-up basis is destined to remain a flashpoint for estate accounting.

How it works

The story begins in 1916, when federal estate tax law was adopted. (Before 1916, temporary death taxes were enacted to raise funds earmarked for special projects such as the formation of the Navy or underwriting the Civil War.) The step-up itself was introduced in 1921 for all types of assets, ranging from real estate to stocks and bonds. The purpose was to avoid double taxation on unrealized appreciation after assets had already been taxed once at fair market value.

The step-up serves as a valuation method of any asset after the owner dies. Essentially, it resets the cost basis for inherited assets, which is to say the original value of the asset, adjusted for commissions, expenses, depreciation, etc. The step-up propels that number forward to be assessed as of the day the owner dies. The intervening years, when the asset may have appreciated, no longer count in the calculation of capital gains tax. In reverse, if the asset has in fact lost value over this time period, the step-up would be negated.

Estates can employ several exceptions. Instead of using the date of death, the personal representatives can opt for a date six months later, assuming the later date reduces the estate’s tax bill. If they go that route, all property must be lumped together for valuation purposes. Representatives cannot select only the advantageous assets. The IRS is also mindful to circumvent tax-designed acquisitions, so the step-up is ruled out for any transfer from heir to owner enacted within a year of the owner’s death.

A costly loophole

Various administrations have struggled to close what they interpret as an elitist loophole, on the grounds that it disproportionately benefits larger estates. So far, they have not succeeded. Repeals advocated by presidents Clinton, Obama and Biden were all unsuccessful.

Fairness arguments aside, there is also a lot of money at stake for government coffers. According to the Congressional Budget Office, replacing the step-up with the original cost basis would generate about $110 billion over 10 years. The federal Joint Committee on Taxation likewise ascribes $42 billion of lost revenues to the step-up in 2021 alone.

The step-up was repealed in 1976, reinstated in 1980, and again challenged and reversed in 1980, in the wake of complaints about record-keeping for old transactions. Recently, opponents of the rule argue that the double taxation concern has lost its teeth when so few pay the federal estate tax anyhow now that the exemption is over $12 million. Opponents also cite revenue distortions. They claim that the step-up promotes a lock-in effect, whereby asset owners resist selling to avoid paying capital gains tax, hindering portfolio choice and liquidity.

Watch out for changing legislation

As a beneficiary, you can use the step-up to minimize your capital gains costs in the estate. You might not even be the first in your family to do so. Successive heirs over many years could keep passing on a property, taking the step-up in each generation and paying little capital gains tax.

Nevertheless, try to keep up to date with any new proposals for eliminating the tax break. Those with real estate in New York City, Los Angeles and other expensive metro areas will have likely seen their home prices escalate. They may withstand the worst of any changes in legislation, while financial portfolios are also affected.

Like so many other tax rules, step-up can get complicated. If you have an inheritance or are planning to leave one, be sure to reach out to your tax manager or a member of our Antares Wealth Management team to make sure you’re taking step-up rules into account.

To learn about one such strategy, be sure to read our article by Tamra Newman, CPA, CVA, about how rising interest rates may favor a charitable remainder annuity trust, or CRAT. 

© 2023

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